Module 17 - Taxation

Question 1

SALES TAXES

Answer 1

SALES TAXES are taxes levied by state and local governments on specified products and services. SALES TAXES are one of the states’ greatest revenue sources. Sales tax is considered a regressive tax because it taxes everyone equally. Therefore, the poor pay a greater percent of their income to sales tax than do the rich.

Question 2

EXCISE TAXES

Answer 2

EXCISE TAXES are taxes on the manufacture, sale, or consumption of nonessential (or excess) commodities within the United States. The states use this tax on items such as liquor, tobacco, and gasoline. An EXCISE TAX is considered a regressive tax, since the same percent is charged to each person upon purchase, regardless of income level.

Question 3

REAL ESTATE PROPERTY TAXES

Answer 3

REAL ESTATE PROPERTY TAXES are taxes on real estate levied by local governments, districts, agencies, and special districts. Education is one of the biggest recipients of real estate property tax revenue. Cities, school districts, and other local agencies with taxing authority levy PROPERTY TAXES on those who own property. Most state governments do not share in property tax revenues. States receive less of their tax revenues from real or personal property taxes than other sources of tax revenues.

Real estate property taxes, usually called AD VALOREM TAXES, are the primary income source to make interest and principal payments on GENERAL OBLIGATION BONDS.

• General obligation bonds are bonds issued by cities and counties. These bonds are discussed in more detail in Municipal Bonds Module 5.

Most of the property tax revenue is put into the general fund and used for the general operation of the municipality. The property tax revenue specifically raised for municipal debt obligations is put into a GENERAL OBLIGATION BOND FUND. No revenue bonds issued by a municipality are paid out of this money.

Property tax is based on the MIL RATE, with 1 mil = $0.001 cents per $1.00 of assessed value. The property is assessed and the mil rate is applied to either the actual assessed value or to a percentage of the assessed value, depending on the charter of the municipality.

Question 4

PERSONAL PROPERTY TAXES

Answer 4

PERSONAL PROPERTY TAXES are taxes on personal property, such as boats and recreational vehicles and, in a business, all of the assets such as machines and furniture. The money from this tax goes into the GENERAL FUND. The personal property tax revenues are also committed to the GENERAL OBLIGATION BOND FUND. The GENERAL FUND is used to pay for general municipal services (police and fire departments, city hall, and so on). The GENERAL OBLIGATION BOND FUND is used to pay the MUNICIPAL DEBT OBLIGATIONS (MUNICIPAL BONDS) of the municipality.

Question 5

ESTATE TAXES

Answer 5

ESTATE TAXES are levied on the estate of a deceased person by the federal government and some state governments.
• Estate taxes are considered PROGRESSIVE TAXES. This is because the higher the value of the estate, the more the estate is taxed. Gift taxes are a form of estate taxes except the donor is still alive. The percentage is the same for gift taxes as it is for estate taxes.

Question 6

INCOME TAXES

Answer 6

The federal government and some state governments levy income taxes on the income received by individuals. The exam is only concerned with federal taxes because there is considerable variation in the amount a state may charge.
INCOME TAXES are considered progressive taxes. This is because the more income a person earns, the higher the percentage tax the person will pay.

Question 7

REGRESSIVE AND PROGRESSIVE TAXES

Answer 7

Both sales taxes and gasoline taxes are considered REGRESSIVE TAXES because the rate applied to each purchase is the same for everyone, regardless of their income. These types of taxes hit people in the lower tax brackets the hardest.

Both income tax and estate taxes are considered PROGRESSIVE TAXES because the rate of taxation increases as the value of the estate increases or as a person’s income increases. With a progressive tax, the theory is that wealthier individuals or estates are capable of paying a higher rate of tax.

Question 8

The U.S. Tax Code currently classifies all income and losses as one of three types:

Answer 8

• ORDINARY: Income or losses from activities of an individual or business. This includes both income and losses.
• PASSIVE: Income or losses from activities in which the individual does not actively participate. This includes income from property that is managed by someone else, losses from depreciation and depletion, and capital gains and losses upon sale of the limited partnership or any other properties that are managed by a third party.
• PORTFOLIO or INVESTMENT: Income or losses from dividends or interest on investments, as well as capital gains and losses upon the sale of securities. The dividends are taxed as ordinary income and if the dividend is from a U.S. corporation, it is taxed at a maximum of 15%; if the dividend is from a foreign corporation, it is taxed at the person’s tax bracket. The capital gains and losses, however, must be reported separately and taxed differently.

Question 9

ACTIVE/ORDINARY INCOME

Answer 9

ORDINARY INCOME is derived from the activities of an individual or business and has the following four components:
- SALARY and/or WAGES: Annual personal income
- OTHER EARNED INCOME: Other sources of income, such as consulting or side jobs
- UNEARNED INCOME: Interest on bank accounts and income from property that is owned and managed by the taxpayer
- LOSSES: Losses on property that is owned and managed by the taxpayer

Question 10

PASSIVE INCOME AND LOSSES

Answer 10

Passive income and losses are derived from activities in which the investor does not have an active role in generating the income or loss. It is typically associated with income from limited partnerships in which the limited partners must rely on the partnership to manage their investment and produce either income or losses. The tax law covering PASSIVE INCOME, PASSIVE LOSSES, CAPITAL GAINS, and CAPITAL LOSSES was mainly developed to counter the abusive deductions that were being taken by investors in LIMITED PARTNERSHIPS. Limited partnerships allow flow-through tax consequences of income or losses to the limited partners. Limited partnerships are discussed in Module 16, Direct Participation Programs.

PASSIVE INCOME is any amount of income credited to the limited partners, whether distributed to the limited partners or kept by the partnership.
• The taxpayer must claim all passive income in the year it is credited to the taxpayer. If the taxpayer has more than one partnership, the taxpayer’s passive income can be offset by any passive losses or capital losses from the other partnerships.
• If there are no passive losses to claim against (e.g., depreciation), and there are no passive capital losses to claim against (e.g., sale of a limited partnership at a loss), the passive income must be added to the investor’s income and taxed.

PASSIVE LOSSES are any expenses, depreciation, depletion allowance, or other deductions generated by the partnership and passed through to the limited partner.
• Passive losses CAN NEVER be used to offset ordinary income at any time. However, passive losses may offset income from other partnerships or income from passive capital gains upon the sale of other partnerships. Passive losses must be reported in the year credited, but such losses may not be used as a deduction by the taxpayer. The loss is noted for later use by the taxpayer and can be used to offset any capital gain on that partnership.

Question 11

PORTFOLIO GAINS AND LOSSES

Answer 11

In a portfolio, CAPITAL GAINS and CAPITAL LOSSES are made when assets, such as stocks, bonds, and limited partnerships, are purchased and sold.

The length of time the assets are held (OWNED) determines if the gain or loss is a SHORT-TERM CAPITAL GAIN/LOSS or a LONG-TERM CAPITAL GAIN/LOSS.
• The asset is considered to be held short term when it is owned for one year or less.
• The asset is considered to be held long term when it is owned for at least one year and one day.

It is important to point out that a short sale of stock and the writing (selling) of options always have a short-term holding period, since investors never own the stock, nor do they own the option.
• Investors may have the position for longer than one year, but the security was sold, not owned, and therefore has to be repurchased when the position is closed.

Question 12

ALTERNATIVE MINIMUM TAX (AMT)

Answer 12

High-income taxpayers who have many deductions must determine the ALTERNATIVE MINIMUM TAX (AMT). If the alternative minimum tax is greater than the taxpayer’s regular income tax, the taxpayer must pay the alternative minimum tax amount.
• The U.S. Tax Code states that taxpayers shall pay their regular tax plus the excess of the alternative tax over the regular tax. This means that taxpayers must pay the tax that is the highest.
• The only taxpayers who are subject to the AMT are those with at least a certain amount in TAX PREFERENCE ITEM deductions (determined by the Internal Revenue Service). Very few taxpayers are actually subject to the AMT.
After the regular income tax is calculated, the taxpayers (or their accountants) must determine the alternative minimum tax. Certain TAX PREFERENCE ITEMS are added to the taxpayer’s income. These items are a deduction under the normal method of determining the amount of income tax due.

Question 13

The TAX PREFERENCE ITEMS for the ALTERNATIVE MINIMUM TAX are:

Answer 13

• Intangible drilling costs — known as IDCs
• The amount of percentage depletion in excess of cost depletion
• Accelerated depreciation — known as “depreciation”
• Interest on municipal bonds that are for private use, such as some revenue bonds and IDR bonds (with the exception of IDR pollution control bonds)
– Revenue bonds, such as those issued for Indian gaming and corporate use, are considered private use
• Other excess expenses or deductions that are being taken at an accelerated amount
• The accelerated depreciation amount over the STRAIGHT LINE amount
– STRAIGHT-LINE DEDUCTIONS — taking the same amount of deductions against interest on premium bonds over time until the bond matures

Question 14

CAPITAL GAINS & LOSSES

Answer 14

A CAPITAL GAIN occurs when an asset is sold for more than it was purchased. A CAPITAL LOSS occurs when the asset is sold for less than it was purchased.
• To determine the amount of gain or loss, subtract the cost of the property (called the COST BASIS) plus any additional costs to acquire the property, from the PROCEEDS of the sale. The PROCEEDS are the total amount that is received upon the sale or liquidation of that asset.
• If the proceeds of the sale are greater than the adjusted cost basis, the investor has a capital gain. If the proceeds of the sale are less than the adjusted cost basis, the investor has a capital loss.


Question 15

TREATMENT OF CAPITAL GAINS

Answer 15

If the purchase and subsequent sale of an asset results in a gain, the gain must be classified as either a SHORT-TERM GAIN or a LONG- TERM GAIN.
• If a short-term gain is realized, add the whole gain to the taxpayer’s ordinary income; the gain is taxed at the taxpayer’s income tax bracket.
• If a long-term gain is realized, the whole gain is only taxed at a maximum of 15%.
• The holding period of capital gains determines the tax treatment of the capital gain.
• The holding period of all capital gains begins on the trade date and ends on the trade date.

Question 16

TREATMENT OF CAPITAL LOSSES

Answer 16

If the purchase and subsequent sale of an asset results in a loss, it must also be classified as either a LONG-TERM LOSS or a SHORT-TERM LOSS to balance against gains.
• If the final result is a loss, it can be deducted from ordinary income up to a limit of $3,000 per year.
• Capital losses from the sale of a limited partnership can be deducted from ordinary income after offsetting the capital loss against other passive income and passive and portfolio capital gains. The loss can also be offset as described in the next section.

Capital losses, whether a PASSIVE CAPITAL LOSS, a PORTFOLIO CAPITAL LOSS, or a combination of both of these, can be deducted against ordinary income to a maximum limit of $3,000 per year. If the capital loss is less than a $3,000, taxpayers can deduct the entire amount against their ordinary income tax. If the capital loss is more than a $3,000, the amount in excess of the $3,000 is carried forward to the next tax year. This CARRYOVER will continue until the entire capital loss is used up.
• The HOLDING PERIOD of all capital losses begins on the trade date and ends on the trade date.
• Every dollar of capital loss may be deducted from taxable income up to a maximum of $3,000 per year. Any amount over the $3,000 is carried over to the next tax year, keeping its classification as either a short-term loss or long-term loss.

Question 17

CAPITAL GAINS VS. CAPITAL LOSSES

Answer 17

When taxpayers have more than one investment with gains or losses, they must follow a process for netting capital gains and losses. The result is that the gains are netted (offset) against losses dollar for dollar up to any amount.
• First, short-term gains and short-term losses are offset against each other, ending with either a net short-term gain or a net short-term loss.
• Second, long-term gains and long-term losses are offset against each other, ending with either a net long-term gain or a net long- term loss.
• Third, if there is a net short-term gain and a net long-term loss, or if there is a net short-term loss and a net long-term gain, these are offset against each other.
• If the final result is a capital loss, the maximum loss that can be deducted per year is $3,000 (as described in Section 3.2, Treatment of Capital Losses).
• If the final result is a capital gain, it is added to ordinary income or taxed at the capital gains tax rate with a maximum of 15% (as described in Section 3.1, Treatment of Capital Gains).

Question 18

PORTFOLIO INCOME

Answer 18

Income from portfolio assets or investments is known as PORTFOLIO INCOME and includes such items as dividends on stock, mutual funds, and REITS, and interest on bonds.
• Dividends received from investments in stocks of domestic corporations (companies in the United States) are taxed at the same rate as long-term capital gains (15% for investors in the 28% tax bracket).
• Dividends from investment companies/mutual funds are considered ordinary dividends and are taxed at the tax payer’s ordinary income tax bracket.
• Taxable interest from corporate and government bonds, bond funds, and other fixed income interest are taxed at the investor’s ordinary income tax bracket.
• However, dividends from REITS and foreign corporations, as well as interest on debt issues are considered portfolio income and are taxed at the taxpayer’s ordinary income tax bracket.
• A portion of dividends from a REIT may constitute a nontaxable return of capital that does not affect the unit holder’s taxable income in the year. The dividend received defers taxes on that portion until the capital asset is sold. These distributions also reduce the cost basis in the REIT, and are then taxed as either a long or short-term capital gain or loss upon sale of the units, depending on the length of time the units are held.
• An investor who receives dividends from a corporation in a foreign country may have to pay a tax to that country. If this is the case, the tax paid in the foreign country becomes a tax credit to the investor when paying taxes in the U.S. on this foreign dividend.
– Remember that a tax credit reduces the taxes owed, and therefore reduces the amount of tax paid due to the dividend.

Question 19

TAX TREATMENT CORPORATE BONDS

Answer 19

All interest from CORPORATE BONDS is added to income and taxed at the investor’s tax rate. The interest is taxed at the federal, state, and local level, if state and/or local income taxes are applicable.
• When a bond purchased at a discount matures, all gains are taxable at both the federal and state level as ordinary income.
• Upon sale of a discount bond prior to maturity, all gains will be part ordinary income and part capital gain/loss, depending on the sale price in relation to the adjusted cost basis.

Question 20

TAX TREATMENT U.S. GOVERNMENT BONDS

Answer 20

All interest from U.S. GOVERNMENT BONDS is exempt from taxes at the state and local levels, but is added to the investor’s income for federal taxes only.
• When a bond purchased at a discount matures, all gains are taxable at both the federal and state level as ordinary income.
• Upon sale of a discount bond prior to maturity, all gains will be part ordinary income and part capital gain/loss, depending on the sale price in relation to the adjusted cost basis.

Question 21

TAX TREATMENT MUNICIPAL BONDS

Answer 21

All interest from MUNICIPAL BONDS is exempt from taxation at the federal level, but is added to the investor’s income at the state level.
• Municipal bonds are also exempt from state and local taxes in the state in which they are issued, but are not exempt in any other state.
• Since this is a national exam, just assume that all municipal bonds are taxed in any state unless the investor is a resident of that state.
• The exam may ask questions that describe the investor being a resident in the same state as the issue. If so, the investor is exempt from both federal and state tax if the municipality and the investor are located in the same state. Since municipal bond interest is tax-free and corporate bond interest is fully taxable, you may be asked to compare which is a better buy.
• When a bond purchased at a discount matures, all gains are taxable at both the federal and state level as ordinary income.
• Upon sale of a discount bond prior to maturity, all gains will be part ordinary income and part capital gain/loss, depending on the sale price in relation to the adjusted cost basis.

You will be asked to compute an equivalent yield on a corporate bond given a yield on a municipal bond, or vice versa.

Use this equation to find the corporate or municipal bond equivalent yields:
CORPORATE BOND YIELD = MUNICIPAL BOND YIELD/100% - TAX BRACKET %

Always remember to use the yield, NOT the coupon in determining the equivalent yield.

Example

A person in the 28% tax bracket wants a corporate bond equivalent to a municipal bond with a 7.5% yield.

CORPORATE BOND YIELD = MUNICIPAL BOND YIELD/100% - TAX BRACKET%
= 7.5%/100% - 28%
= 7.5%/72%
= 10.42%

The fact that interest from municipal bonds is exempt from federal taxes and interest from government bonds (federal government bonds) is exempt from state taxes stems from a reciprocity ruling by the U.S. Supreme Court. The Supreme Court determined that “states may not tax the taxpayers on the interest of federally issued securities, and the federal government may not tax the taxpayers on interest of municipal issued securities.” Just remember: “The agency that issues the bond can tax the interest from the bond.”

All municipal notes are short-term, issued at a discount, and mature at par value. The appreciation from its discounted price to its par value at maturity is the interest that is earned by the investor. Therefore, there is no capital gain on municipal notes held until maturity.

If municipal bonds are purchased at a discount in the secondary market and held until maturity, the gain is treated as ordinary income at maturity. If sold prior to maturity, a new cost basis will be determined and then a possible capital gain/loss will be recognized.

Question 22

BONDS OF TERRITORIES AND PROTECTORATES

Answer 22

The bonds of territories and protectorates include bonds issued, for example, by state or municipal authorities in Puerto Rico and Guam. The interest on these bonds is TRIPLE EXEMPT. This means that the interest is not taxed at any level: Federal, state, or local.

Question 23

TAX TREATMENT OF ALL BONDS

Answer 23

Bonds purchased at a premium or a discount have different tax treatments. Depending on whether the bond is purchased as an original issue or in the secondary market, the loss or gain will be taxed differently; however, it will never be a capital loss or capital gain if held to maturity.


Question 24

BONDS PURCHASED AT A PREMIUM

Answer 24

When investors buy a bond at a premium either as new issue or in the secondary market, and hold the bond until maturity, they cannot take a capital loss at maturity.
• If the bond is a municipal bond, the investor loses the premium paid and no loss can be deducted at any time.
• If the bond is a corporate or government bond, the investor can amortize the premium over the years until maturity and deduct the amortized amount of loss each year against the interest income received.
– The amortization is a “straight-line” amortization of the premium that is subtracted from the cost basis each year.

AMORTIZATION is the gradual reduction of the value of a capital asset over a period of years for tax purposes. Some amortizing of a capital asset is deductible from personal income, such as with corporate and government bonds, and some is not, as with municipal bonds.

If any bond is sold prior to maturity, the investor must determine the new cost basis using the amount amortized each year; at the time of sale or redemption, the investor uses the new cost basis to determine whether the sale is a gain or loss.

Examples
1. David purchases an 11% 10-year corporate bond for $1,100. The bond is held until maturity. What is the gain or loss at maturity?

Since David can deduct the amortized premium against the interest income at maturity, there is no capital loss.

2. Emily purchases a 6% 10-year municipal bond for $1,100. The bond is held until maturity. What is the gain or loss at maturity?

Since Emily has purchased a municipal bond, she must amortize the premium without taking any deductions, and there is no capital loss at maturity. The IRS just does not allow the loss. The thinking is that the interest is tax-free; therefore, no deduction is given for the premium.

Question 25

BONDS PURCHASED AT A DISCOUNT

Answer 25

When a bond is purchased at a discount, the appreciation (gain) that will be received at maturity must be ACCRETED over the life of the bond. The process of ACCRETING the difference in value between the discounted amount and the maturity value follows one of two tax rules. Either the purchase is a new issue purchase, referred to as an original issue discount (OID), or it is a purchase in the secondary market.

Question 26

OID Bonds and Treasury Receipts (STRIPS)

Answer 26

OID Bonds and Treasury Receipts (STRIPS)
• The original issue discounted amount represents the amount of interest that will be received. It is the difference between the purchase price and the maturity price (par value) that accumulates between the time the bond is originally sold until it matures.
• If the bond is a municipal bond, the accreted amount is treated as the interest credited to the municipal bond and is, therefore, tax-free.
• If the bond is a corporate bond, the accreted amount is the interest credited to the bond and, therefore, must be claimed as interest income each year.
• A zero-coupon bond is a form of an OID bond. Therefore, there is no capital gain if held to maturity.
– Treasury receipts and corporate zero coupon bonds are treated this way and each year the accreted amount is taxed as ordinary income.
– The accretion is a “straight-line” accretion (amortization up) of the discount and is added to the cost basis and taxed each year.

Example

Susan buys a corporate zero-coupon bond for $400 with 15 years to maturity. If the bond is held to maturity, what will be her capital gain?
Answer: $0. The bond must be accreted $40 per year ($1,000 - $400 = $600 ÷ 15 years = $40 of accretion per year) and is taxed as ordinary income.
Therefore, the last year also has $40 interest; however, there is no capital gain.

If the bond is a zero-coupon bond purchased at a discount and sold prior to maturity, there could be a gain or loss in addition to the interest credited to the bond.

Example

Eric buys a corporate zero-coupon bond for $400 with 15 years to maturity. If the bond is held one year and sold for $500, what will he have?
Answer: $40 interest, $60 capital gain. The interest is calculated as in the previous example. The bond must be accreted at $40 per year ($1,000 - $400 = $600 ÷ 15 years = $40 of accretion per year). So, after the first year, the bond has accreted to $440. Therefore, the capital gain is everything above $440. Since the bond was sold for $500, there is a $60 capital gain ($500 - $440).

Question 27

Secondary Market Discount Bonds

Answer 27

All bonds (municipal, corporate, and government) bought at a discount in the secondary market have the accreted gain taxed as ordinary income if held to maturity. Do not confuse this gain as a capital gain. This accreted gain is treated as ordinary income for the investor.
• The accreted gain is a “straight-line” accretion that is added to the cost of the bond each year.
• The accretion can be taxed each year or taxed when the bond is sold or matures. The investor has the choice.

Example

Paula buys a 10-year San Francisco city bond for $800 in the secondary market. If she holds the bond until it matures, she would have a $200 gain. This gain is treated as ordinary income, and thus added to her income.

If Paula sells the bond for $900 after holding it for four years, what will she have?

The bond at maturity will be worth $1,000, then subtract the price that the bond was purchased at ($800) to arrive at $200 discount.
$1,000 - 800 = $200
Now, calculate the accretion per year:
$200 ÷ the 10 years to maturity = $20 per year.
Then, calculate the amount of accretion for the time the bond has been held:
$20 × 4 years held = $80
Add the accreted interest to the price at which the bond was purchased to arrive at the new cost basis:
800 + 80 = $880
Subtract the selling price from this new basis: $900 - $880 = $20
This represents the amount of capital gain.

She has ordinary income of $80 and a $20 capital gain that will be taxed as a long-term capital gain, since the bond was held for four years, or offset against other capital losses.

In this last scenario, if Paula can only sell the bond for $850, she will have a capital loss. In this case:
$880 - $850 = $30 capital loss in addition to the $80 ordinary income. The $80 will be added to her income as interest income, and the $30 per bond capital loss will be deductible from her ordinary income or offset against capital gains on other investments.

Question 28

TAX TREATMENT OF Unexercised Options

Answer 28

If options go UNEXERCISED, the premium is treated as:
• For options positions that are short (short call or short put),
the gain is a short-term capital gain in the year the option
expires.
• For options positions that are long (long call or long put), the
loss is a short-term capital loss in the year the option expires.
– The premium received for written options is always considered a short-term capital gain if the option expires unexercised. The option was never owned.
– The premium paid for the purchase of an option is always considered a short-term capital loss if the option expires unexercised.
– The only exception is if the investor has a LEAP option, which can be for more than one year, and then the loss would be a long-term loss at the time the option expires.

Question 29

TAX TREATMENT Closing Options Positions

Answer 29

When investors CLOSE their option positions, the resulting gain or loss is always a short-term capital gain or loss.
• This is regardless of whether the person was long or short the option, since all options but LEAPS are for less than one year.

Question 30

TAX TREATMENT OF Exercised Options

Answer 30

If an option that is either purchased or written is EXERCISED, the premium of the option is:
• ADDED to the STRIKE PRICE to determine the COST BASIS or PROCEEDS if the option is a CALL (buy or sell respectively)
• SUBTRACTED from the STRIKE PRICE to determine the COST BASIS or PROCEEDS if the option is a PUT (sell or buy respectively)

Question 31

For an investor who writes a CALL OPTION, the premium is added to the PROCEEDS from the sale of the stock when the option is exercised.

Answer 31

Example
Write a 70 call for a premium of 5; when exercised, the writer’s proceeds are $7,500 per option contract.
Since it is a call, to calculate the proceeds, add the premium to the call price of 70. Remember, “call up.” The premium received was $500. If a call that is written by an investor is exercised, the writer must sell the shares at the strike price, which in this case is $70. If 100 shares are sold at $70, the proceeds would be $7,000. If we add the premium that was received for the call option, the total proceeds equal $7,500.

Question 32

For an investor who purchases a call option, the premium is added to the cost basis of the stock when the investor exercises the call.

Answer 32

Example
Buy a 70 call for a premium of 5; when the buyer of a call exercises the option, the premium (5) is added to the 70 strike price in determining the cost basis of the stock. Again, think “call up.”


Question 33

For an investor who writes a PUT OPTION, the premium is subtracted from the cost of the stock when the option is exercised and the investor is forced to purchase the stock.

Answer 33

Example
Write a 70 put for a premium of 5; when exercised, the writer’s cost basis of the stock is $6,500.
To calculate a put, subtract the premium from the put price of 70. Remember, “put down.”

Question 34

For an investor who purchases a put option, the premium is subtracted from the proceeds of the sale when the investor exercises his put and receives the proceeds for the stock.

Answer 34

Example
Buy a 70 put for a premium of 5; when the buyer of a put exercises, the premium (5) is subtracted from the 70 strike price in determining the proceeds of the stock.
Again, think “put down.”

Question 35

Regardless of whether the investor is a buyer or a writer, to find the cost basis or the proceeds, remember “call up” for calls and “put down” for puts. If the option is a call, whether buy or sell, add the premium to the strike price; if the option is a put, whether buy or sell, subtract the premium from the strike price.

Answer 35

REMEMBER FOR TEST

Question 36

CONVERTED STOCK

Answer 36

Stock that has been CONVERTED from bonds or preferred stock continues the holding period of the security from which it was converted. Therefore, the holding period begins when the investor purchases a convertible bond, not when the bond is converted to stock.
STOCK DIVIDENDS and STOCK SPLITS are treated similarly to CONVERTED STOCK, except that the total value received is divided by the total amount of stock now held to determine the cost basis per share. The stock will have a lower cost basis per share, but there will be more shares held.

Question 37

SHORT SALES

Answer 37

SHORT SALES are always considered a SHORT-TERM CAPTIAL GAIN or LOSS when the position is closed because the customer never owns the stock since the stock was borrowed to deliver for the short sale. There is a holding period on the short position in the stock, but not the stock itself because the investor did not actually own the stock. An investor has to own the stock to establish a holding period for Internal Revenue Service (IRS) purposes.

Question 38

WASH SALES — NOT ILLEGAL OR A VIOLATION

Answer 38

A WASH SALE is defined as selling a security at a loss and purchasing or repurchasing the same security (or a substantially similar security) within 30 days before or after the sale of that security.
• Purchasing a call option on a stock position that has been sold within this time frame is also considered a wash sale. This is true regardless of whether the call is in or out of the money.
• Selling an in-the-money put option on a stock position that has been sold within this time frame is also considered a wash sale.
• If a short put positions is out of the money, a wash sale is not invoked because the stock is not guaranteed to be repurchased at the lower price.

A wash sale is not illegal, nor is it a violation when done by an individual investor.
• The IRS does not allow investors to recognize a loss when they execute a wash sale.
• The IRS believes that investors are still in the same position as they were before the repurchase.

Example
Henry buys 100 shares of stock at $60 for a total of $6,000. Toward the end of the year, he calculates that an investment loss could reduce his tax liability. The stock that he previously purchased is currently selling at $50 per share. He sells the stock on December 23 at $50 per share, for a total of $5,000. Then on January 5 of the next year (less than 30 days later), he buys 100 shares of the stock again at $49. The IRS does not allow the $1,000 loss.

Of course, if the above example had resulted in a gain, the IRS gladly considers the gain as income for the investor.

You may also encounter a question on your exam where the investor is short to start with, then buys at a loss, and within 30 days “re-shorts” substantially the same stock. The IRS also considers this a wash sale.

***For the test, look for a wash sale any time you see a specific date on which a trade is made!

Question 39

INTEREST EXPENSE

Answer 39

INTEREST EXPENSES are deductible expenses. The interest expense paid for purchasing stock is deductible as an expense from income.

The interest expense incurred is not deductible if the borrowing is used to invest in tax-exempt securities (municipal bonds). This is true regardless if the expense is more than the tax-exempt income received on the bonds. If the borrowed funds are used to invest in tax-exempt securities, interest expense is not tax-deductible.

Question 40

INVESTMENT COMPANY TAXATION

Answer 40

Ordinary Dividends, Interest, and Short-Term Capital Gain Distributions

All ordinary dividends, interest, and short-term capital gains distributed by an investment company are taxable to the shareholder at the shareholders’ ordinary income tax bracket in the year distributed.

Long-Term Capital Gains Distributions

All capital gains that are distributed by an investment company (mutual fund) are treated as long-term capital gains and taxed in the year received. The gain is always treated as a long-term gain, even if the mutual fund was only held for a short time (less than one year). Long-term capital gains distributions are a result of the trading activity that happens within the fund from the buying and selling of assets by the fund manager.

As you may have surmised, short and long-term gain distributions from investment companies are handled differently. Short-term gain distributions are combined with ordinary dividend and interest distributions. Therefore – short-term gain distributions cannot be offset by other portfolio losses to reduce tax liability. Long-term capital gain distributions can be offset by other portfolio losses to reduce the investor’s tax liability.

The Sale of Investment Company Shares

All capital gains that are realized because of a sale of investment company shares are considered long or short-term capital gains or losses and are taxed upon the sale of the shares. In this case, to assess if the gain resulting from the sale of the shares was a long-term or short-term gain or loss, the length of time the mutual fund shares were owned is relevant. Short or long-term gains and losses are then combined with other portfolio gains and losses to determine the investor’s tax liability for portfolio income or loss.

Question 41

CORPORATE EXCLUSION

Answer 41

Corporations do not pay any federal income tax on interest from municipal issues, though they do pay federal tax on interest from government and corporate issues. In addition, corporations do not have to pay full taxes on dividends from corporate equity securities (stock).
Currently, the maximum tax rate for corporations is 35%, meaning corporations pay a 35% tax on dividends they receive from investments in other corporations. This is currently the highest corporate tax rate among industrialized nations.

Question 42

UNIFORM GIFTS TO MINORS ACT (UGMA)

Answer 42

An account under the UNIFORM GIFTS TO MINORS ACT (UGMA) is established for the benefit of a minor. UGMA ACCOUNTS are also known as UTMA (UNIFORM TRANSFER TO MINORS ACT) ACCOUNTS. UGMA accounts are discussed in detail in the Module 11, Customer Accounts. Here, we only discuss the maximum annual tax-free gift limit and the taxation of income to an UGMA account.

An unlimited value of gifts can be given to a minor in an UGMA account. However, the maximum tax-free gift to a minor per donor per year is $14,000. Therefore, a husband and wife can give $14,000 each, or $28,000 total, to a child.

Any amount donated to a UGMA/UTMA by one donor in excess of $14,000 is taxable to the donor as a gift tax.

Income for the purpose of an UGMA account is the dividends on stock and/or the interest on bonds held in the UGMA account. Any income earned by a minor in an UGMA account is taxable to the minor at the minor’s income tax rate in the year it is paid.

The same rules apply to a gift given to another adult.

When securities are given to a minor (or any other person) as a gift from a living person, the cost basis in the securities for the donor becomes the cost basis to the minor (or other person) who receives the securities.

Example:
A father gives his daughter 200 shares of stock that are presently trading at $50 per share, for a total of $10,000. The father paid $30 per share when he purchased the stock. The cost basis for the daughter is $30 per share.
The value of the gift, for gift tax purposes, is the value of the securities as of the date the securities are given: $10,000. The cost basis is the original cost to the father, or $6,000.

When securities are given to a minor (or any other person) because of a “last will” from a deceased person, the cost basis to the minor (or other person) who receives the securities is the value on the date of death of the person who bequeaths the stock.

Example:
A father dies and leaves his daughter 200 shares of stock that were trading at $50 per share on the date of his death, for a total of $10,000. The stock is trading at $60 when the shares are given to the daughter. The father paid $30 per share when he purchased the stock. The cost basis to the daughter upon sale of the stock is $50 per share, the value on the date the father died.

Question 43

DONATIONS

Answer 43

Donations to charities may qualify as a deduction from ordinary income.
• If the donated property has been held for one year or less, the original cost basis of the property (usually stock) is all that can be deducted.
• If the property has been held for more than one year, the market value on the date of the gift is the amount that can be deducted.

If no holding period is provided in a given question on your exam, assume the holding period was more than one year and use the market value of the property on the date of the gift.

Question 44

TAXATION OF DIVIDENDS AND INTEREST ON FOREIGN SECURITIES

Answer 44

Investors who live in the United States but invest in stocks and bonds of companies in foreign countries must pay federal taxes on the dividends and interest received.
• The investor may also have to pay taxes to the country where the company is located.
• If investors pay taxes to the country where the company is located, they are able to deduct the foreign tax from their taxes payable in the United States, called a tax-credit.
The taxpayer has the choice of:
• Claiming a tax credit against taxes due in the United States, or
• Claiming a deduction from income in the amount of the dividend and/or interest taxes that were paid

You do not have to know how to compute taxes, you only need to know that investors in foreign corporations may claim tax credits based upon taxes paid to foreign countries.

Question 45

TAXATION OF WITHDRAWALS FROM QUALIFIED AND NONQUALIFIED RETIREMENT PLANS

Answer 45

The two types of retirement plans are nonqualified and qualified.
Nonqualified plans are retirement plans where the contribution is deposited after the participant has paid taxes on the money that will be contributed. Thus, we say the contributions are NOT tax deferred. Examples are:
• Variable annuities

Qualified plans are retirement plans where the contribution is deposited prior to paying taxes, and thus we say the contributions are tax-deferred. Examples are:
• IRAs
• 401(k) plans
• Defined benefit and defined contribution plans
• Profit sharing plans
• Keogh plans
Contributions to IRAs may be thought to be paid with after-tax dollars; however, if the contributor takes a tax deduction for the contribution, then the contribution is still considered tax-deferred. Even though the employer did not make the contribution, the individual did, but then took all or part of the contribution as a tax-deduction. This is considered tax-deferred. Any amount to an IRA that is not deducted is treated as a nonqualified plan and becomes part of the contributor’s “cost basis,” and thus will not be taxed upon withdrawal.

In a NONQUALIFIED retirement plan, the contributions are NOT tax-deferred since income tax has already been paid on that money, and withdrawals of this money will not be taxed or penalized at any time.

In a QUALIFIED retirement plan, the contributions ARE tax- deferred, since the income tax has yet to be paid, and withdrawals of this money will ALWAYS be taxed, and penalized if certain conditions have not been met.

However, in both qualified and nonqualified retirement plans, the appreciation accrues tax-deferred, meaning that upon withdrawal, a tax must be paid on the appreciation.
• In addition, if the contributor has not yet reached age 59 1/2, an additional 10% penalty tax is charged on the amount withdrawn that has been deferred.
• The amount that is taxed as ordinary income also has an extra 10% penalty tax. The amount withdrawn with after-tax dollars is not taxed, nor is there a penalty tax.

Remember, for a withdrawal from both qualified and nonqualified plans, the penalty tax is only on the same amount that is subject to ordinary income tax.

Question 46

Nonqualified Plans

Answer 46

A person in a NONQUALIFIED retirement plan who takes a partial withdrawal is first considered to be taking the amount that has appreciated in the account, and then the rest of the withdrawal is considered the cost basis. Thus, the first dollars taken are taxed as ordinary income up to the amount appreciated, and then all other dollars taken are tax-free as return of cost basis.

Therefore, the amount taken that is the appreciation is taxed as ordinary income only, provided the person is 59 1/2 or older or, if the person has not yet reached 59 1/2, as ordinary income plus a 10% penalty tax.
• If the amount taken is less than the amount the account has appreciated, the whole amount is taxed as ordinary income, plus an additional 10% penalty tax, if applicable.
• If the amount taken is more than the amount the account has appreciated, the whole amount of the appreciation is taxed as ordinary income, plus a 10% penalty tax, if applicable. The remainder is the cost basis and thus no tax or penalty is charged.


Example
A person has contributed $50,000 to a nonqualified plan. The plan has risen to $60,000. Since this is a nonqualified plan, only the amount taken up to $10,000 is taxed, plus penalty where applicable. The person is now 45 and wants to take a withdrawal of $8,000. How is the withdrawal taxed?
$8,000 is taxed as ordinary income plus a 10% penalty.
The person is now 45 and wants to take a withdrawal of $12,000. How is the withdrawal taxed?
$10,000 is taxed as ordinary income plus a 10% penalty; $2,000 is not taxed as it is the contribution that already has been taxed.
The person is now 65 and wants to take a withdrawal of $8,000. How is the withdrawal taxed?
$8,000 is taxed as ordinary income and there is no 10% penalty.
The person is now 65 and wants to take a withdrawal of $12,000. How is the withdrawal taxed?
$10,000 is taxed as ordinary income and there is no 10% penalty; $2,000 is not taxed as it is the contribution that already has been taxed.



Question 47

Qualified Plans

Answer 47

A person in a QUALIFIED retirement plan who takes a partial withdrawal is taking the whole amount as untaxed money, and thus must pay ordinary income on the whole amount. (Note the difference between this and a non-qualified plan.)
Therefore, depending on the age of the person, the amount taken is taxed as ordinary income only, provided the person is 59 1/2 or older, or as ordinary income plus a 10% penalty tax if the person has not yet reached 59 1/2.


Example
A person has contributed $50,000 to a qualified plan. The plan has risen to $60,000. Since this is all pre-tax dollars that are taken, it is all going to be taxed, plus a penalty where applicable. The person is now 45 and wants to take a withdrawal of $8,000. How is the withdrawal taxed?
$8,000 is taxed as ordinary income plus a 10% penalty.
The person is now 45 and wants to take a withdrawal of $12,000. How is the withdrawal taxed?
$12,000 is taxed as ordinary income plus a 10% penalty.
The person is now 65 and wants to take a withdrawal of $8,000. How is the withdrawal taxed?
$8,000 is taxed as ordinary income with no 10% penalty.
The person is now 65 and wants to take a withdrawal of $12,000. How is the withdrawal taxed?
$12,000 is taxed as ordinary income with no 10% penalty.


Question 48

There are six ways that a person is allowed to take withdrawals from both a nonqualified and a qualified plan without a penalty, of which you only need to know five:

Answer 48

• In the case of death or disability
• To pay for higher education for someone in the family (even
nieces and nephews)
• To purchase or remodel a first home
• Taking payments that equate to a retirement
• Extraordinary medical expenses


Question 49

In addition, you need to know the following regarding when withdrawals must be made. Depending on whether the plan is qualified or nonqualified, there is a difference.

Answer 49

• Qualified plans must start taking contributions by April 1 in the year AFTER the person has turned 70 1/2. (If a person turns 70 on April 29 and 70 1/2 on October 29, this person must start taking withdrawals periodically or all at once by April 1 the following year.)
• Nonqualified plans do not ever have to start taking money from the plan, regardless of age.

Persons in a nonqualified plan who take withdrawals that equate to a retirement (over their life expectancy) have a part of each payment as their cost basis with no tax, and the other part as the appreciation and taxed as ordinary income. Regardless of the age, there is NO penalty tax (yes, even if the person is 45 years old and takes the withdrawals for 30 plus years).

Persons in a qualified plan who take withdrawals that equate to a retirement, have 100% of each payment taxed as ordinary income, since it has all been deferred. Regardless of the age, there is NO penalty tax (yes, even if the person is 45 years old and takes the withdrawals for 30 plus years).


A person has contributed $100,000 to a nonqualified plan over the last 20 years. The plan has risen to $600,000. The person is now 45 and wants to take withdrawals that equate to a retirement. How are the withdrawals going to be taxed?

Since part of this is with after-tax dollars and the appreciation is with pre-tax dollars, part of each payment is the return of cost basis and another part is taxed. No penalty tax is incurred.
One-sixth of each payment is tax-free.
Five-sixths of each payment is subject to ordinary income tax.

A person has contributed $100,000 to a qualified plan over the last 20 years. The plan has risen to $600,000. The person is now 45 and wants to take withdrawals that equate to a retirement. How are the withdrawals going to be taxed?
Since this is all pre-tax dollars that are taken, it is all going to be taxed. However, no penalty tax is incurred.
100% of each payment is subject to ordinary income tax.